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2008 09

I have an op-ed in today’s Age on the politics behind the government’s intervention in the market for residential mortgage-backed securities.

It was pleasing to see the Australian Financial Review take a strong editorial stance against the intervention (‘Swan Banks on a Very Bad Idea,’ AFR, 29 September 2008, p. 62). The AFR attributed the very transparent politics behind the intervention ‘to the Hollowmen school of policymaking.’

To reinvigorate the Australian RMBS market and support competition in mortgage lending, I will direct the AOFM to invest in AAA rated RMBS in two initial tranches of $2 billion each.

The government’s intervention in the RMBS market shows that we don’t need a GSE to support market liquidity. Both the RBA and AOFM can perform this function, if deemed necessary.

I doubt an intervention of this size will do much to ease liquidity premia or see much pass through to retail mortgage interest rates. But even allowing for some small pass through, all the government has done is marginally weaken the case for further reductions in the official cash rate by the RBA. Whatever the AOFM giveth, the RBA will surely taketh away.

It is not hard to imagine that Labor politicians are left wondering how they appear to have gotten themselves alligned [sic] with Terry McCrann and the CIS. The answer is that the advice they are getting is flawed both ideologically and factually.

Since this is much the same advice that the government has been getting from those notorious right-wing think tanks, the RBA and Treasury, one can only assume that Joshua thinks that these institutions are similarly in error. What exactly does it mean to be ‘ideologically flawed’ anyway?

The main reason the Treasurer is uninterested in AussieMac is that we already have institutions such as the RBA that stand ready to supply market liquidity, to the extent that it is needed. The experience both in Australia and overseas has been that central bank liquidity operations have been undersubscribed. Governor Stevens complained at the most recent House Economics Committee hearing that they practically had to brow-beat the market into stumping-up enough RMBS.

The government can also assist home buyers directly, without needing to intermediate that assistance through a GSE and the mortgage securitisation industry. The UK government has taken this more direct approach, but we are a long way from needing that sort of intervention in Australia.

The RBA can be expected to calibrate its new easing cycle to conditions in credit markets. If the banks fail to fully pass on cuts in the official cash rate, the RBA will just cut by larger amounts to get the desired change in retail lending rates.

the downturn in energy has blindsided the industry veteran, leaving one of his hedge funds that focuses on energy stocks down almost 30% through August. A smaller commodity-focused fund is down 84%.

All in, the funds have lost around $1 billion this year, a figure that includes $270 million of personal losses. “It’s my toughest run in 10 years,” said Mr. Pickens, a former geologist who earned billions by building an oil company and investing in energy. “We missed the turn in the market, there’s nothing fun about it.”…

Mr. Pickens says he’s shifted his funds’ portfolios to a more neutral stance, to keep his losses in check. That means he hasn’t fully benefited as oil prices jumped in the past few days to $106.61 a barrel from about $90.

Contrary to the picture of Freddie and Fannie painted by Christopher Joye and Joshua Gans, Charlie Calomiris and Peter Wallison highlight their role in causing rather than ameliorating the credit crisis:

In order to curry congressional support after their accounting scandals in 2003 and 2004, Fannie Mae and Freddie Mac committed to increased financing of “affordable housing.” They became the largest buyers of subprime and Alt-A mortgages between 2004 and 2007, with total GSE exposure eventually exceeding $1 trillion. In doing so, they stimulated the growth of the subpar mortgage market and substantially magnified the costs of its collapse.

It is important to understand that, as GSEs, Fannie and Freddie were viewed in the capital markets as government-backed buyers (a belief that has now been reduced to fact). Thus they were able to borrow as much as they wanted for the purpose of buying mortgages and mortgage-backed securities. Their buying patterns and interests were followed closely in the markets. If Fannie and Freddie wanted subprime or Alt-A loans, the mortgage markets would produce them. By late 2004, Fannie and Freddie very much wanted subprime and Alt-A loans…

So it was that, beginning in 2004, their portfolios of subprime and Alt-A loans and securities began to grow. Subprime and Alt-A originations in the U.S. rose from less than 8% of all mortgages in 2003 to over 20% in 2006. During this period the quality of subprime loans also declined, going from fixed rate, long-term amortizing loans to loans with low down payments and low (but adjustable) initial rates, indicating that originators were scraping the bottom of the barrel to find product for buyers like the GSEs.

I have an op-ed in today’s AFR arguing against the ban on short selling, which is reproduced over the fold (text may differ slightly from the edited AFR version).

Richard Heaney from RMIT provides the other side of the argument on the same page. Heaney concedes that banning short selling makes no sense if the market is behaving rationally, but questions ‘whether the equity market is behaving rationally at present.’ I would argue that you need to be consistent in your choice of behavioural model. It makes no sense to argue that the same investors who were rational one day are suddenly irrational the next.

Macro Man, channeling A E Houseman, puts the case against short selling restrictions more poetically:

Smart lad, to turn the other cheek
And hide as regulators seek,
A culprit for the tempest’s wind
And those that profited and sinned

By selling as the tide went out,
Revealing who was left with nowt.
No more, your selling of the banks
Neither the Brits’, nor else the Yanks’:

Now you will not swell the rout
Of long investors getting out.
The emperor’s new clothes can stand
Unmolested by your hand.

Following is a review of Robert Shiller’s The Subprime Solution, part of a longer review essay I’m preparing on ‘Depression Economics.’

Robert Shiller’s The Subprime Solution illustrates the extent to which New Deal mythology still has a stranglehold on contemporary thinking about the recent credit crisis. Shiller romaticises the New Deal, maintaining that ‘somehow a spirit of cooperation and change developed… ultimately embodied in the New Deal; while there was great unrest, there was also a sense of positive institutional change and progress, which offset the despair of the Depression. Hostility between labor and management, and between rich and poor, was tempered by the sense that we were all moving together toward a more enlightened world’ (p. 99). Shiller argues against ‘waging war on the financial elite’ (p. 177) in response to the recent credit crisis. But as Amity Shlaes demonstrates in her history of the Great Depression, the New Deal was anything but cooperative and enlightened and waged an indiscriminate war against all levels of society.

iPredict is New Zealand’s first real money prediction market. In addition to the usual political contracts, iPredict is running markets on whether New Zealand will be in recession with the June quarter GDP release, as well as the September quarter CPI outcome.

Property sector funds management and indices business Rismark International has called on the federal government to introduce an “Aussie Mac” mortgage financing conduit along the same lines as ailing US giants Fannie Mae and Freddie Mac.

But Rismark managing director Christopher Joye said the differentiator for Aussie Mac would be that it remained in government hands, given that he considered the demise of Fannie and Freddie to be directly attributable to dominance supplied through government guarantee.

In the near- to medium-term we would expect AussieMac to be privatised with the result that its debt would be taken off the government’s own balance sheet.

Joye and Gans can’t seem to make up their minds whether they want AussieMac to be publicly or privately-owned, but ownership in and of itself does not define the nature of the relationship with government (just ask any US taxpayer). As they noted in their original paper, AussieMac would be ‘leveraging off the Commonwealth’s secure credit rating.’ In other words, its position in capital markets would be defined by its relationship to the government’s credit rating, which in turn depends on the government’s power to tax.

In their original paper, Joye and Gans said that ‘Fannie Mae and Freddie Mac have been extraordinary successful institutions for the best part of 50 years.’ Joye now concedes that ‘There’s a question as to whether Fannie and Freddie were conceived in the right manner.’

The only point of difference between the US GSEs and AussieMac is that Joye and Gans argue that AussieMac should be kept strictly limited in scope:

Mr Joye said his vision for Aussie Mac would be that it ordinarily sat on the sidelines, and would not actively pool mortgages, repackage them and on-sell the vehicles to promote liquidity.

Instead, Aussie Mac would lie in wait as a backup in the case of any liquidity crisis.

As I noted in my paper on AussieMac, the RBA already provides a much more robust infrastructure for supporting market liquidity. There are few limits in principle to the RBA providing liquidity in relation to an almost limitless range of counter-parties and assets, if deemed necessary. The only rationale for AussieMac is thus to create a GSE that would be soft touch for the mortgage securitisation industry compared to the RBA.

Peter Wallison argues that the Paulson rescue plan will further entrench Freddie and Fannie:

Recent statements by Barney Frank (D., Mass.), the chairman of the House Financial Services Committee, and Chuck Schumer (D., N.Y.), a powerful member of the Senate Banking Committee, make clear that Congress will never let them be privatized, broken up, slimmed down, nationalized or any of the other options hopeful reformers are putting forth today. Fannie and Freddie in their current form are just what Congress wants: an inexhaustible source of campaign contributions and funds for favored groups.

Here’s how it works. Fannie and Freddie are backed by the federal government, which allows them to borrow money at interest rates lower than any other shareholder-owned company. With these cheap funds, they buy and hold mortgages and mortgage-backed securities with considerably higher yields.

But the huge profits from this government-subsidized arbitrage do not mean lower mortgage rates for the American homebuyers. Studies by the Federal Reserve have shown that Fannie and Freddie have essentially no effect on mortgage rates. The profits instead go to shareholders and managements, lobbyists, favored community groups, and of course to members of Congress through campaign contributions.

The Paulson plan, regrettably, will restore these two companies to their positions as poster children for corporate welfare.

Gans suggests that the main difference between us is that I don’t ‘believe that markets work imperfectly.’ In fact, all markets are necessarily imperfect to some degree and I do not know of many economists who argue otherwise. The issue is whether government intervention can improve on market-based outcomes.

We probably do have different interpretations of the credit crisis, reflecting a somewhat different view of the functioning of markets. Market efficiency does not mean that markets never make mistakes. What matters is whether they are ultimately self-correcting. We may not particularly like the price signals generated by this process, but that does not mean that the price signals are wrong.

Gans suggests that ‘to spend time attacking Freddie and Fannie is not particularly useful for the Australian debate.’ Since AussieMac was explicitly modelled on Freddie and Fannie (hence the name), the US experience must be relevant, unless one can point to significant differences between AussieMac and the US GSEs.

Gans correctly singles out the implicit government guarantee as the main problem with Freddie and Fannie, but making the guarantee explicit, as the US has done now, does not entirely solve the problem. As Gans concedes, this still leaves taxpayers on the hook, which may create perverse incentives. Gans says ‘Kirchner appears here to be arguing that the government should come out and say that it will not bail-out any Australian bank or large non-bank should it get into financial difficulty.’ My view is that government should if anything guarantee certain classes of depositors rather than financial institutions. Policymakers should aim to keep private financial risk off the government’s balance sheet. Gans wants Australian taxpayers to take effective ownership of 5-10% of the market for residential mortgage-backed securities, but with no mechanism to ensure that the government’s funding advantage in capital markets would be passed on to consumers.

On housing affordability, Gans says that:

Kirchner also argues that our proposal will increase the demand for housing and therefore, not improve housing affordability. This is a common mis-conception. Put simply, the ONLY way our proposal will increase the demand for housing is by making the financing of that housing more affordable.

I should have been clearer on this point. Lower lending rates would only add to demand all else being equal. But as Gans correctly points out, all else is not equal. Lower rates would likely feed through to house prices, with adverse implications for both housing affordability and demand. Housing affordability is really a function of the supply and demand for houses rather than the supply and demand for housing finance.

Gans says of the US rescue plan for Freddie and Fannie that ‘the big losers will be shareholders in Fannie and Freddie, the very people Kirchner were arguing were the big winners in this game.’

It is quite likely that shareholders in Freddie and Fannie will be wiped-out, but only after decades of using public guarantees to secure private profits. The fact that shareholders may ultimately be wiped-out is of no comfort to anyone. Gans has not addressed the issue of the failure to pass through their funding advantage to consumers.

He has also not addressed the issue of whether the Reserve Bank would trade-off any reduction in retail lending rates against changes in the official cash rate. The calculator on the AussieMac web site, which purports to show the cost of not proceeding with AussieMac, actually works against the proposal. Could the RBA ignore an easing in credit conditions of the magnitude suggested by their calculator? I doubt it.

Joshua Gans has actually been using the problems with Freddie and Fannie as an argument in favour of AussieMac. Following Robert Shiller, he suggests that:

the privatised Fannie and Freddie cannot do the job of ensuring liquidity in home mortgage markets and a new government owned and operated entity is required. Thus, despite all that has happened in the US this past year, it looks like they might need an AussieMac too.

The issue is not whether Freddie and Fannie should be privately or publicly-owned. Their implied government guarantee meant that Freddie and Fannie were always effectively part of the balance sheet of the US government.

The problem with the two US GSEs has been that their formerly implicit, and now explicit, government guarantee blurred the lines between private and public risk-taking. Their enormous profits earned at the expense of consumers may have accrued to private shareholders, but it was always understood by those who invested in Freddie and Fannie’s debt and equity that taxpayers were backstopping the two GSEs. This created incentives for excessive risk-taking, which is what ultimately brought them unstuck.

Joye and Gans have set up a web site devoted to debating their AussieMac proposal, where you can find their original and follow-up papers.